Compound interest refers to the interest accumulated on the principal amount, in addition to the interest from previous periods; this allows you to maximize your earnings on the principal sum. Interest can be compounded on any frequency schedule, whether it’s daily, monthly, or annual. The formula for compound interest is as follows:
A = P(1 + r/n)^nt
Where:
A = the total amount of money at the end
P = the principal amount invested or borrowed
r = the annual interest rate
n = the number of times interest is compounded within a specific time period
t = the number of these time periods that have elapsed
Compounding interest is a good way to make the most of your principal amount when it comes to saving and investing. For instance, holding $10,000 in an account with a 4% annual interest rate compounded for five years will eventually leave you with $12,166.53 — $166.53 more than if the interest does not compound.
Compound interest can also apply to loans. For example, if you borrow $10,000 at an annual interest rate of 5% without compounding, you will be required to pay $500 in interest after a year. However, if you pay this loan off monthly on a compound interest basis, you would have paid $511.62 in interest payments by the end of the year.
Compound interest can be an effective way to grow wealth over time, as the interest earned on the accumulated interest can compound and eventually grow exponentially. On the flip side, compound interest on debt can result in significant costs over time if the debt is not paid off quickly.